Market backdrop
Market backdrop sentiment improved in June, particularly over the first half of the month following the US debt ceiling resolution. Spreads on EUR IG corporates were circa 8 bps tighter on the month to 162 bps. Away from the US debt ceiling story, the focus remained on central banks and inflation. The narrative from central banks remained on the hawkish side, which led to rates moving higher on the month (10-year bund yield +0.1% to 2.4%). Inflation figures remain high, especially in the UK, where these surprised to the upside, prompting more dramatic moves in rates. EUR IG corporate total returns were negative on the month (-0.44%) as higher rates more than offset the impact of tighter spreads.
Performance
The fund’s NAV during the month (Z class, EUR) was down 0.05%. Performance has been driven by the impact of higher rates overall, as well as the underperformance of USD and GBP-denominated bonds compared to EUR-denominated bonds as rates rose considerably (10-year UK gilt yield up 56 bps in June for example). This was roughly offset by the strong performance of Additional Tier 1 (AT1) contingent convertibles (CoCos) and Tier 2s from insurance companies that outperformed senior debt and Tier 2s from banks
Positioning
Despite less favourable market conditions, we saw USD 5.2 billion of fresh supply of green bonds in June solely from the banking sector, which compares to USD 2.7 billion in June 2022. Total supply of green and sustainability bonds from European financials in 2023 to date has totaled USD 36 billion, or close to three quarters of 2022 total supply. New issues came only in senior format, from a broad mix of different banks. We participated in a new issue from Bank of Ireland, a new senior bond maturing in 2031 (callable in 2030), with a yield of 5.1% or 274 bps of spread to government bonds – highly attractive in our view. Irish banks performed fairly well over the month, following the upgrade by S&P of Bank of Ireland and AIB’s ratings to BBB – driven by a stronger macro backdrop, higher profitability from higher rates and sustainably lower levels of non-performing loans.
This led the Tier 2s of both AIB and Bank of Ireland to become investment grade-rated (IG) on average (average of S&P, Moody’s and Fitch ratings) and hence enter several IG indices – a positive technical.
Outlook
We remain positive going forward – with upcoming Q2 earnings from European banks expected to remain a catalyst for the sector. Earnings are expected to be strong, reflecting robust capital, resilient asset quality, the uplift in earnings from higher rates, and no issues around liquidity or deposit outflows. In brief, we believe the European financial sector remains one of the strongest sectors from a bondholders’ perspective.
With a yield (to next call) of around 5.8% and an average spread (G-spread) of circa 300 bps on the fund (compared to 4.4% / circa 160 bps for the EUR IG corporate market), we see this as an opportunity to capture high income with upside potential from tightening spreads. This is despite the high-quality bias of the fund (average bond rating of BBB+ / average issuer rating of A) and lower duration compared to EUR IG corporates (4.4 versus 4.5).
